Wednesday, 15 March 2017

Is the Shiller PE Ratio a Good Valuation Tool for the Stock Market ?

 Shiller CAPE Ratio 

I have seen the Shiller PE Ratio chart making the rounds in the internet lately. It has been used as evidence that the stock market is overvalued. I have even seen prof. Robert Shiller - a Nobel laureate in economics - appeared on CNBC a few times lately pointing out that the stock market is overvalued based on the chart that bears his name.

I reckon that chart is evaluating the stock market without the most important context of all: interest rates (Fed Fund Rate or bond yield, to be exact). Surely, we can't measure the stock market in any meaningful way without comparing it to its interest rate environment.

During 2016, there is the much talked about topic of TINA (There Is No Alternative) condition in the investment landscape. I.e. the stock market kept going up while the earnings are declining, and the GDP growth was slowing to a crawl. This is attributed to the fact that when bond yield is negligible (and in some parts of Europe and Japan, bond yield is negative). In this environment, what's the point of putting money in bond when you're guaranteed to lose money?

Hence, there's no alternative but putting money into shares. For this reason, share prices would benefit a higher p/e ratio because of lower bond yield. (No, i don't think the Fed lowers FFR (Fed Fund Rate) to lift asset prices. Maybe partly for the Wealth Effect. Mainly, the Fed drop rates to reflate the disinflation / deflation since the Great Recession of 2008 (actually this occurred long before 2008). Asset price rises is just a side effect. Not the cure).

In summer, woolen sweater are cheap, but the same woolen sweaters could double in price, and we still need to buy it. You've no alternative (the alternative is hypothermia. Or in the case of investment, erosion of wealth).

Earnings are important (it's the "E" in PE ratios), but it must also be priced in relation to interest rates (directly influenced - if not controlled - by FFR), and not just its historical context. In other words, both earnings and bond yields affect price (the "P" in PE ratios).

Shiller PE and Cape ratio, and fed fund rates
Source: Shiller PE Ratio comes from multpl.
(Click chart to enlarge)

Let's compare the charts of Fed Fund Rates and Shiller PE Ratios side by side (or top and bottom). Here are a few things of note.

The 2 peaks in Fed Fund Rates (~1920 and ~1980) correspond to 2 bottoms in Shiller PE Ratios. Not surprisingly, a trend of increasing FFR lead to contraction of PE ratios. This makes sense. That's the whole point of increasing rates.

E.g. In 1980, the market topped with a p/e = 7 ! Yes, single digit. But the inflation was 14%! Yes, double digit. While this is an anecdotal evidence, but it fits in everything in this article. So today we have historical low inflation, we should expect historical high p/e.

* The 2 rate hike cycles (~1900 - 1920, and  ~1970 - 1980) lead to declining PE ratios.

* Life is never so simple. We can have period of rate hike and increasing PE ratios at the same time such as those in ~1940 - 1970. The red line that denotes pivotal rate (~5%). We're in this zone right now where we can have a growing PE ratios and increasing FFR at the same time. Once we're above this pivotal rate, we're starting to kill the PE ratios, as seen from the chart. This is because our economies can't handle high FFR (and high is defined as anything over ~5%).

Another way of looking at the 2 distinct periods between 1950 to 1980 is this: in the 1st period from 1950 to 1970, the Fed performed normalization of rates, which tends to steepen the bond yield curve, and this is good for economy and market (expansion of market p/e). In the 2nd period, the Fed tried to rein in inflation, which tends to flatten the bond yield curve, and that's bad for economy and equity market (contraction of market p/e). We're clearly in the 1st period now with the Fed normalizing rates.

 Fund Flows Between Bond and Stock Markets 

Clearly, one can't just look at PE ratios alone. Remember that the bond market is more than twice as big as the equity market, its fund flow to the equity is therefore quite significant.

The rise and fall of bond yield leads to the fund flows between the bond and share markets, and contributing to the the fall and rise of the share market. The bond yield in turns is greatly influenced by Fed Fund Rate.

Therefore FFR determines the flow of money between bond and stock market. Or more accurately, money are seeking the best returns for the investment money, or best bang for the bucks. Surely, that has to be the most important gauge for investments, always.

Fund flows model between Bond and stock markets
When Fed Fund Rate is low, fund will flow from bond to share market, leading to increased liquidity
in the share market, thus causing its prices (and p/e) to rise.

So, let's look at the Shiller PE Ratios right now in the context of Fed Fund Rates. We have the lowest Fed Fund Rate on this chart going back for more than 100 years, and yet we don't have the highest Shiller PE Ratios today.

To put it another way, if the Shiller PE Ratio that we have today is the same value (~43) as the Tech Bubble top of 2000, our stock market is still cheaper because the FFR is considerably lower today than year 2000. Of course, i'm not saying a PE ratio of 43 is cheap. I'm saying that if we have Shiller PE Ratio = 43 today, it's considerably undervalued when compare to the days of the Tech Bubble. Since the Shiller PE Ratio is under 30 right now, is it cheap or expensive?

Well, the price of 10 Year U.S. Treasury Note is about 43 times its annual interest payment, which happens to be the Shiller PE Ratio for the Tech Bubble peak of 2000. In other words, if today's p/e ratio is the same as the S&P 500 p/e ratio of the peak of 2000, the market is fully valued. Since we're well below that, the market p/e is cheap because of the high 10-year treasury bond price (or historically low yield).

In summary, both the bond and stock market are competing for the same investment money. They're competitors just as shoes companies competing for our money. To compare the p/e ratios of a stock market with its past records is like comparing the price of brand X shoes with its past prices.

What you really want is comparing the price of shoes of brand X with the price of brand Y today. Not the past. Of course, one can compare the price of brand X shoes with its past to get some idea of what prices are considered expensive in the past, but it's much more relevant and useful to compare brand X shoes with its main competitor of brand Y in the same timeframe.

If the price of brand Y shoes are expensive (read bond prices), then even if the prices of brand X shoes (read stock prices) are more expensive now than its historical prices, we still want to buy brand X shoes because we don't want to pay for higher priced brand Y shoes.

Bond markets have been in bull market in the last 30 years while stock markets have bear markets with several severe corrections. Bonds are therefore much more expensive than stocks. Or to put it another way, if the yield of 10 Year T Note today is, say 8% (which is lower than the 1980s), why would Wall Street even want to hold equity? Unless S&P 500 has a low single digit PE ratio.

It would make sense to look at the Shiller CAPE Ratio if share market exists in isolation. In other words, no significant competitor for money in the equity market from other market. Not only this is simply not the case, the stock and bond markets are in fact joined at the hips (shown in my drawing above).

I've seen countless articles that put up the Shiller CAPE Ratio chart without questioning its validity, and stating it as 'proof' that the stock market is very overvalued, and as if all matter are settled, end of discussion. That has to be the most dangerous thing one can do. If i can place a slither of doubt in them (or more importantly their readers), i've done my job.

For those who keep insisting in showing this chart that the market is soon to correct based on the high Shiller Cape Ratio, they should read what the professor said about the usefulness of his chart as a predictive tool here. He questions the usefulness of Shiller Cape Ratio as a timing tool (but people are using it for that exact purpose). If the bond market (and gold market to an extent a lesser - much lesser - market) is an important competitor for money, then why not just use bond market (brand Y shoes) as gauge of stock market (brand X shoes) valuation model?

 The Low FFR Normal 

We're in a goldie locks period that's more similar to the period between ~1950 to 1970 with increasing Fed Fund Rate and inflation from a low base. As long as the Fed kept the Fed Fund Rate well below 5%, the market should benefit from it (assuming the economy isn't running into some spanner in the works like Sub-prime bubble).

I have a feeling that the Fed will keep FFR considerably lower than 5% for sometimes to come. I don't think the share market can withstand even a 3% FFR. We're living in the Age of Disinflation causing by the 3 megatrends of globalization, aging demographics, and most of all, technology (which leads to lower prices of energies, goods, and services). These megatrends won't go away any time soon, and the Fed and central banks around the world will have to contend with low FFR to combat those powerful drivers of disinflation.

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